The valuation of the target company is a substantial element of any given acquisition transaction. This article showcases the DFCF (debt free cash free) standard for enterprise valuation and the issues raised in the context of transaction contracts. The DFCF valuation is a calculation that ignores how the target company’s business is funded. The DFCF valuation shows the value of the company without accounting for the net cash or net debt held by the company, either on average during the year, or at closing.

The DFCF calculation is useful for several reasons. The offers made by potential purchasers to the same target are more easily compared to one another under the DFCF valuation. DFCF values may more accurately reflect the investor’s approach, because from the purchaser’s perspective the way of financing is of no relevance when evaluating the target. By way of the DFCF standard, potential purchasers ignore the target’s financing structure and can filter out constant changes in the cash and debt position of the target company until the completion of the transaction. Due to these reasons the DFCF valuation has become standard in M&A transactions.

The DFCF value of the target company is by no means equal to the purchase price of the shares. At closing, the purchase price of the company’s shares needs to be determined by way of adjustment of DFCF value on the basis of the net debt (debt minus cash) position of the target company. The main principle here is that cash holdings at the time of closing must be added to the DFCF value while the debts outstanding must be deducted, to arrive at the purchase price.

To accomplish this, an indebtedness statement needs to be prepared to show the net debt of the target at the closing date. The methods of calculating net debt (average of the year, or as existing at closing) must be made clear in the contract to avoid disputes. Tight cooperation between legal and financial advisors is indispensable. The treatment debt depends whether it is an intra-group or a third party debt. While the target usually pays back inter-group loans at closing, the treatments of third party creditors may be more complicated, such as those arising out of options and costs of early repayment, the change of control and the termination provisions in the financing agreement and the costs of financing etc. These issues must be checked during legal due diligence so that the transaction agreement could address them clearly. The accurate wording of the transaction agreement in relation to the DFCF value and the adjustment of it is necessary to express the interests of the purchaser and the seller in a fair manner. These types of considerations lead us to issues relating to adjustment clauses and closing accounts that will be dealt in another article.